Different volatility numbers tell you different things. Is one more useful than another? Let's find out.
Volatility (vol) values are like clues in a scavenger hunt. Each one might reveal the perceived risk of an option and how that exposure could affect your overall trading strategy.
You know vol is important. But should you look at overall implied vol (IV), the IV of each options expiration, or the IV of each option within an expiration?
Overall IV. Use this as a big-picture metric to get a general sense of where vol is in a specific symbol’s options. You can also use it to compare the vol of one symbol to another.
Overall IV of each expiration. Consider this a blended vol, based on a basket of options within a given expiry.
IV of each option within an expiration. This is the vol input (along with stock price, days to expiration, interest rate, and dividend yield) for a theoretical options-pricing model that makes the theoretical options contract price equal to the market price. If the market, and theoretical price, of an option is $3 with a 25% vol input, that option has a 25% implied vol.
Fire up the thinkorswim® platform from TD Ameritrade. Select the Trade or Analyze tab and enter a stock symbol. You’ll notice different vol numbers (see figure 1). Let’s explore how they’re calculated.
These IVs are used to calculate the greeks and probability numbers you see for each option. If you base your strategy on the probability of an option expiring worthless, that probability uses the IV of the option in its formula. If you want to sell a covered call against long stock where the call has a certain delta, say 0.30, that delta uses the IV of the option in its formula.
Individual IVs are also used to calculate the greeks for options positions, which you can find in the Position Statement section of the Monitor tab. When vol changes, those greeks change, too, and they can change your position’s risk exposure. If you beta weight your portfolio, changes in vol can have a compound effect, changing the greeks of your underlying positions and any hedges you have. In a word, pay close attention to IV.
Depending on your trading style, any one of these vol numbers could be more important than the others. But consider all of them for clues so you can get the best sense of where vol exists for a given symbol.